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Budget
It is important that short-term Budget decisions are consistent with long-term sustainability. The illustrative 30 year projections presented in this annex assist in assessing sustainability and generational equity. The key points are:
A1. In setting fiscal policy it is important for the Government to ensure that its short-term decisions are consistent with a sustainable long-term framework. Failure to do so would see the costs of current policy being pushed on to future generations with detrimental effects to long-term economic growth. This outcome would also be inconsistent with the principles of fiscal management set out in the Code for Fiscal Stability and, in particular, with achieving fairness between generations.
Code requires illustrative long-term projections
A2. For this reason, the Code requires the Government to publish illustrative long-term projections for a period of at least 10 years. The first set of these projections was published in Budget 99. They showed that the UK was in a relatively strong long-term fiscal position and that current consumption could grow at a slightly faster rate than economic growth and remain consistent with meeting the fiscal rules.
A3. The projections in this annex build on those published last year to provide an update on the sustainability of UK fiscal policy. As the factors affecting long-term sustainability are not likely to change significantly from year to year, the overall position has not changed markedly. However, this set of projections incorporates updated demographic projections and some minor refinements to the assumptions and methodology to provide additional insight.
A4. The analysis of long-term sustainability is still being developed, not only in the UK but also in a number of other countries. The Government will continue to analyse long-term spending trends to ensure the public finances remain sustainable and provide fair outcomes to present and future generations.
DEMOGRAPHIC TRENDS
A5. The demographic challenges the UK faces, along with other EU and OECD countries, emphasise the importance of a sound long-term fiscal strategy. As shown in Chart A1, around one in four people in the UK will be aged 65 or over by 2036, compared to around one in six in 2000.Chart A1: UK population by age and sex
The UK is ageing ...
A6 This future ageing of the UK population, however, is broadly comparable with past trends. Over the period 1981 to 2000, the average age in the UK across the entire population has risen from just over 37 to nearly 39 years. The increase projected for the next 20 years is only a little faster with the average age rising to around 41 1/2 years.
A7 The ageing of the population in the UK is expected to be less pronounced than in most European countries. This is reflected in the low projected increase in the age dependency rate shown in Table A1.
... but not as much as the rest of Europe
| Age1 | Total2 | |||||
| per cent | per cent | |||||
| 2000 | 2020 | Increase | 2000 | 2020 | Increase | |
| United Kingdom | 26.3 | 32.3 | 6 | 68.9 | 70.4 | 1.5 |
| France | 27.1 | 35.4 | 8.3 | 70 | 75.8 | 5.8 |
| Germany | 26.2 | 35.5 | 9.3 | 60 | 64.5 | 4.5 |
| Italy | 29.1 | 40.2 | 11.1 | 60.1 | 67.1 | 7 |
| United states | 21.2 | 28.2 | 7 | 69.4 | 69.8 | 0.4 |
| Japan | 27.4 | 48 | 20.6 | 60.7 | 83 | 22.3 |
A8.These factors mean the impact on the UK of an ageing population is expected to be manageable. Nonetheless, the issue cannot be ignored. The reduced proportion of the population of traditionally working age and the greater demand for services for the aged will both have implications for government spending and revenue.
A9.The Treasury's model for long-term fiscal projections examines the sustainability of the public finances by determining at what rate current consumption (current spending on health, education,) can grow while still allowing the Government to meet its fiscal rules. This is done by projecting forward taxation and transfer payments and capital consumption (depreciation), with the difference indicating the resources available for current consumption. This methodology is set out in more detail in Box A1.
| Box A1: Long-term projections methodology | |||
| The methodology used for calculating long-term projections starts from assuming that the Government's golden rule will be met over the long term. As the model uses a steady state without any economic cycle, this is equivalent to meeting the golden rule in every year, or in other words, that: | |||
| CSt=CRt | (1) | ||
| Where | CSt = current spending in year t; and | ||
| CRt = current revenue in year t. | |||
| Current spending consists of current consumption, capital consumption (depreciation)and transfer payments (namely social security and debt interest payments). This can be written as: | |||
| CSt=CCt+KCt+Trt | (2) | ||
| Where | CSt = current spending in year t; and | ||
| CRt = current revenue in year t. | |||
| Trt = transfers in year t. | |||
| Inserting equation (2) into equation (1) then gives: | |||
| CCt = CRt - KCt - Trt | |||
| The model then solves for current consumption by using projections of current revenue, transfers and capital consumption as discussed in this chapter. | |||
A10.The projections of taxation, transfers and capital consumption are intended to show the impact of extending current policy settings forward. In many cases, however, it is difficult to define what represents current policy from a modelling perspective. As such a number of assumptions are made to approximate the current settings. These assumptions are set out below.
A11.Table A2 sets out the key economic assumptions underlying the projections1. Over 30 years the range of plausible assumptions is large. However, consistent with the approach to projecting the public finances in the short term, the assumptions used here take a cautious view. In particular, the expected effects of the Government's reforms to increase labour market activity and productivity are not taken into account in the baseline scenario. The importance of labour market participation is examined as an alternative scenario later in this annex.
| Average annual real growth, per cent | ||
| 2005-06 to 2009-10 | 2010-11 to 2029-30 | |
| Productivity | 2 | 1 3/4 |
| Labour force | 1/4 | 0 |
| GDP | 2 1/4 | 1 3/4 |
| Inflation | 2 1/2 | 2 1/2 |
Cautious economic assumptions for the long term
A12.The overall long-term rate of economic growth used in the projections is lower than the Government's neutral projection of trend economic growth2. This reflects the use of cautious assumptions for both labour force and productivity growth. The reason for introducing this additional caution is twofold. First, the greater uncertainty involved over the long term suggests taking a more cautious approach. Second, a number of the effects driving higher short-term economic growth may not continue in perpetuity. For example, higher productivity growth may reflect "catch-up" effects for a while and female participation rates cannot be expected to continue to grow forever.
A13.Tax revenues are subject to a number of influences in both the short and long term. For example, changing patterns of income and spending give rise to considerable uncertainty about tax bases.
Constant overall tax revenue as a share of GDP
A14.The long-term implications of these effects, however, are difficult to project in a meaningful way. For this reason, the approach used is to project total current receipts as a constant share of GDP without making assumptions about the source of that revenue. This approach is equivalent to saying that the Government will continue to raise the same relative amount of revenue as is currently the case. Although pressure may arise on certain tax bases in the long term and it is quite likely that some sources of taxation will decline or grow in relative importance, it is assumed that the Government will offset these effects in a revenue neutral way.
Spending assumptions
A15.As current consumption is calculated as the difference between receipts and other spending, the main spending assumptions relate to transfers and capital consumption.
Social security projections use the current framework
A16.Transfers are made up of three separate components: social security transfers, interest payments and other transfers. The projections of social security transfers are calculated in conjunction with the Department of Social Security and take into account the current social security framework.
Interest payment projections use market interest rates
A17.The calculation of interest payments requires assumptions both about interest rates and the level of investment. As for the short-term forecasts, interest rates are modelled using market expectations and the existing spread of financial assets to which those rates apply. The amount of investment is determined by assuming a constant investment profile at the same proportion of GDP from 2004-05 to 2019-20. From 2020-21 the rate of investment is reduced slightly to stabilise net debt at 40 per cent of GDP. This approach is consistent both with meeting the sustainable investment rule and, in the absence of an explicit investment target beyond 2004-05, current policy settings. The net debt trend is discussed in more detail in the following section.
Capital consumption projections use historical data
A18.Capital consumption is based on the forward profile for investment which provides information on additions to the capital stock. The consumption of both the existing stock of assets and these new additions is then calculated on the assumption that future public sector asset lives are broadly similar to those evident in the past.
A19.As with all projections, the outcomes reflect the inputs and assumptions. The assumptions set out above reflect current policy settings but cannot, and do not, attempt to pre-empt future policy decisions. For this reason, they should be interpreted as illustrating a potential long-term position rather than presenting an expectation about the future.
A20.The baseline projections are set out in Chart A2. These illustrative projections show that, given the assumptions for transfer payments and taxation, public sector current consumption can grow at an average real rate of around 21/2 per cent a year and still remain consistent with meeting the fiscal rules.
A broadly sound long-term fiscal position
A21.The main reason that current consumption can grow faster than GDP is the declining trend for transfers as a share of GDP. This in turn is primarily driven by the projected path for social security benefits. As the majority of benefits are indexed by prices, they remain constant in terms of purchasing power and fall as a share of GDP over time. Falling debt interest payments as a share of GDP in the medium term also contribute to the reduction in transfers.
A22.These illustrative projections produce a broadly similar picture to that presented last year. There have, however, been some small changes. Most notably, the long-term rate of growth of transfers has increased slightly primarily as a result of updated demographic projections. In addition, the projected rate of investment is higher than that used last year producing higher net debt and debt interest payments in the long term. As a result, the sustainable rate of current consumption growth has fallen slightly and current consumption broadly stabilises as a share of GDP between 2019-20 and 2029-30. This situation is offset by short-term improvements in the public finances so that the overall picture is largely unchanged.
A23.The projected changes in net debt emphasise the importance of ensuring sound public finances in the short term to prepare for future developments. On current projections net debt falls to 32.6 per cent of GDP in 2004-05. This downward trend, however, is not projected to continue indefinitely. Rather, net debt is projected to rise, and stabilise slightly below 40 per cent of GDP.
A24.The main reason for this longer-term increase in the net debt ratio is the combination of continuing strong public sector investment and the cautious projection of trend growth over this period. Should real economic growth be closer to 2 per cent a year then the debt to GDP ratio would stabilise at around 38 per cent of GDP. However, it is important to take a cautious approach in the baseline projections and not to anticipate the long-term effects of the Government's policies to raise productivity and labour market participation.
A25.The general conclusion of the baseline projections has been supported by work undertaken by the National Institute of Economic and Social Research (NIESR). NIESR's generational accounts3 for the UK suggest only a modest generational imbalance and a broadly sustainable position. Further information on generational accounts is set out in Box A2.
A26.It is important, however, that the Government does not become complacent in the light of these positive projections. These data need to be interpreted with caution as they are subject to a number of uncertainties over a long period. Changing mortality, fertility or migration trends may produce a different population profile from that currently expected with consequential effects on the demand for social security, health and education services. In addition, the demographic trends provide no information on 'expected healthy life', which adds uncertainty to projections of health and social security spending.
A27.Aside from demographic uncertainty, there are a number of expenditures which the Government will face in the future about which the cost is uncertain - such as nuclear decommissioning. In addition, there are uncertainties about the demand for, and cost of providing public services over time. For example, changes in the structural level of unemployment and deviations in public sector pay, particularly relative to productivity, may affect spending pressures. Similarly, efficiency gains in all spending areas should reduce the cost of providing services.
Box A2: Generational AccountingAn alternative method of analysing long-term fiscal sustainability and generational equity is through the use of generational accounts. These accounts calculate the net tax burden (the difference between taxation and government benefits) that an individual will pay over their remaining lifetime. By comparing the net tax burden faced by newborns (a proxy for the current generation) with that of future generations it is possible to examine the extent to which current policies imply a transfer between generations. The National Institute of Economic and Social Research (NIESR), partly funded by the Treasury, has produced a set of generational accounts for the UK1. These accounts suggested that the UK was in a broadly sustainable long-term position and that any generational imbalance was relatively modest.
Generational accounts are also available for a number of other countries. A recent publication by the National Bureau of Economic Research (NBER)2, compares generational accounts for 17 countries. As is evident in the chart below, this study shows widely differing long-term situations across the various countries as measured by the increase in taxes required to restore generational balance. 1.Generational Accounting in the UK by Roberto Cardarelli, James Sefton and Laurence Kotlikoff, November 1998.2.Generational Accounting Around the World, edited by Alan Auerbach, Laurence Kotlikoff and Willi Leibfritz, 1999. |
Policy reforms are in place to minimise the effect of ageing on the public finances
A28.These future uncertainties require the Government to develop policies that take the ageing of the population into account and minimise the risk of the public finances becoming unsustainable. The future increase in the retirement age for women from 60 to 65 will play an important role in reducing long-term spending pressures. In addition, the Government has announced:
A29.These developments will all play an important role in ensuring sustainable public finances in the long term.
A30.It is important to examine the effect that changes in the key assumptions may have on fiscal sustainability. Last year's Economic and Fiscal Strategy Report illustrated the effects of stronger economic growth and higher investment. This year an alternative scenario examines the importance of the Government's labour market programmes.
Higher labour market participation
A31.One of the main concerns about the ageing of the population is the effects that it could have on the labour market and in turn economic growth. This concern is based on the existing trend of people - males in particular - reducing their involvement in the labour market before reaching the statutory retirement age. There is, however, no reason why this trend should continue. Improvements in health and the demand for the skills developed by older members of society mean that employment opportunities will continue to exist for all. In addition, policies such as the New Deal are helping to get people back into the labour market right across the age spectrum.
A32.The effects of increasing labour market activity are shown in Chart A3. This chart presents a scenario in which the participation rate across all ages increases by 4 percentage points between 2010 and 2020 (with the increase weighted towards older age groups).
A33.This scenario clearly emphasises the importance of labour market participation. The increase modelled here allows real growth in current consumption to rise by 1/4 per cent to average 23/4 per cent a year over the projection period. This would allow the Government either to increase spending and/or reduce taxes by an average additional amount of almost £1 billion each year in 1999-2000 terms.
A34.The main driver of this outcome is the fact that economic growth has increased along with the increase in the labour force. In addition, spending on transfers falls slightly as benefit recipients move into the workforce. The resulting combination of higher tax revenues and lower social security transfers leaves the Government in a stronger fiscal position.
Higher labour market participation will improve long-term sustainability
A35.This outcome emphasises the importance of the Government's programmes to improve labour market participation. Even small increases in participation rates can support relatively large increases in current consumption. However, it should be noted that the scenario does not model the expected effect of the Government's policies to reform the labour market although it does show the importance of these policies.
A36.As indicated in previous long-term projections by the Treasury, as well as by NIESR, the UK's public finances are broadly sustainable in the long term. The strength of this position is in contrast with that expected in many European countries.
A37.The Government will, nonetheless, continue to examine the potential impact of both the ageing of the population and other long-term effects. This reflects the high degree of uncertainty surrounding long-term analysis of fiscal trends and the fact that small changes in economic and policy variables can have significant effects over the long term.
A38.It is for this reason that the Government already has in place a number of measures designed to offset the effect of ageing on public spending and revenue. The importance of some of these measures is demonstrated in the alternative scenario modelled above. This emphasises the reasons for the Government's efforts to improve labour market participation. These measures, and the publication of illustrative long-term projections, will help to ensure that short-term policy decisions are set firmly within a sustainable long-term framework.
